Intermediate Financial Management (with Thomson One)

Assume that you have just been hired as a financial
analyst by Tennessee Sunshine Inc., a midsized Tennessee
company that specializes in creating exotic
sauces from imported fruits and vegetables. The
firm’s CEO, Bill Stooksbury, recently returned from
an industry corporate executive conference in San
Francisco, and one of the sessions he attended was
on the pressing need for smaller companies to institute
corporate risk management programs. Since no
one at Tennessee Sunshine is familiar with the basics
of derivatives and corporate risk management,
Stooksbury has asked you to prepare a brief report
that the firm’s executives could use to gain at least a
cursory understanding of the topics.
To begin, you gathered some outside materials
on derivatives and corporate risk management and
used these materials to draft a list of pertinent questions
that need to be answered. In fact, one possible
approach to the paper is to use a question-andanswer
format. Now that the questions have been
drafted, you have to develop the answers.
a. Why might stockholders be indifferent whether
or not a firm reduces the volatility of its cash
flows?
b. What are six reasons risk management might
increase the value of a corporation?
c. What is corporate risk management? Why is it
important to all firms?
d. Risks that firms face can be categorized in many
ways. Define the following types of risk:
(1) Speculative risks
(2) Pure risks
SELECTED ADDITIONAL REFERENCES
For an excellent overview of risk management, see
Froot, Kenneth A., David S. Scharfstein, and Jeremy
Stein, “A Framework for Risk Management,”
Journal of Applied Corporate Finance, 1994, Vol.
7, no. 3, pp. 22–32.
862 • Part 7 Special Topics
(3) Demand risks
(4) Input risks
(5) Financial risks
(6) Property risks
(7) Personnel risks
(8) Environmental risks
(9) Liability risks
(10) Insurable risks
e. What are the three steps of corporate risk management?
f. What are some actions that companies can take
to minimize or reduce risk exposures?
g. What is financial risk exposure? Describe the
following concepts and techniques that can be
used to reduce financial risks:
(1) Derivatives
(2) Futures markets
(3) Hedging
(4) Swaps
h. Describe how commodity futures markets can be
used to reduce input price risk.
i. It is January and Tennessee Sunshine is considering
issuing $5 million in bonds in June to raise
capital for an expansion. Currently, TS can issue
20-year bonds at 7 percent, but interest rates are
on the rise and Stooksbury is concerned that
long-term interest rates might rise by as much as
1 percent before June. You looked online and
found that June T-bond futures are trading at
111-25. What are the risks of not hedging and
how might TS hedge this exposure? In your
analysis, consider what would happen if interest
rates all increased by 1 percent.
For additional insights into the use of financial
futures for hedging, see the following publications:
Blake, Marshall, and Nelda Mahady, “How Mid-
Sized Companies Manage Risk,” Journal of
Applied Corporate Finance, Spring 1991, pp.
59–65.